Cleanse credit ‘ecosystem’ of toxic debt

Dear Debt Adviser,
I first took out loans to pay for college four years ago. I defaulted because I was back in school, out of a job and out of money. The college loans went to collection. I am working now, paying $900 a month for the past four months on them. I have other debt issues, however. I have paid off three credit cards, and have a fourth that is in collection. I also owe $4,600 on my car. Does paying the debts that are in collection help improve your score at all? How long will it take to get my credit score of 528 to a decent level? I don’t see me having any new credit problems, just fixing the ones that I had. Help me, please.— Mike

Dear Mike,
I get this type of question a lot. Examples: Does this action improve my credit score? How long will it take for my score to recover? Because you seem focused on the near future, let me start by saying that paying all your collection accounts will help your score. How long will it take? Let me try to get you to understand your situation from a different frame of reference, and then things may make more sense.

Your credit report and score are part of what I call your credit “ecosystem.” Think of the shellfish in the Gulf of Mexico that depend on microscopic food and clean water to thrive. They’re part of a larger food chain and ecosystem. Then BP spills millions of barrels of crude into the Gulf for months.

Even after the pollution stops and cleanup begins, it takes time for the environment to recover. The same thing applies to your credit ecosystem. You have a lot of debt pollution in your credit report. You may have stopped adding to the mess, but the pollution is still there and it will take time to recover. If you never cleaned up your debts, it would take much, much longer to recover than if you didn’t.

With that said, here are some specifics. The major credit scoring models — FICO and VantageScore — look back at two to three years of your payment history to come up with a score. Negative items on your credit report, such as collection accounts and defaulted student loans, count against your score whether they are paid or unpaid in the short term. But problems count for less as they age. Newer, positive information — such as your repayments — helps dilute the polluted data in your report. But it will be seven years before it disappears completely.

Your score will improve as you add positive information to your credit report. You do this by making all your payments on time and as agreed. Open new accounts only as you need them, and keep your ratio of credit available to credit used as low as you can. This is known as your credit utilization rate.

The other ingredient to improve your credit score is time. The more time that elapses from your collection and defaulted accounts, the less impact they will have on your score. Keep plugging away at paying off your debts and maintaining a good payment record with your other obligations, and your credit score will steadily increase. You should see significant improvement over the next two years or so.

Although paying off your collection accounts won’t have an immediate positive effect on your credit score, it will help in other ways. A local lender, car dealer or landlord may use more than a score in deciding whether to do business with you. Seeing that you are paying or have paid collection accounts may help them decide that you are a worthwhile risk.

Then, take steps to protect yourself in the future. In uncertain times, it is important to build an emergency savings cushion. I recommend saving enough to cover six to 12 months’ living expenses. It will take time. But the next time you have a toxic spill in your credit ecosystem, you’ll be better off if you have some “clams” tucked away in a safe place.

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